Chronicles of a ‘Failed State’ 5

(Vyacheslav Dombrovsky) Assistant Professor, Stockholm School of Economics and Baltic International Center for Economic Policy Studies

People in power often choose their entourage (public officials) by attaching a large weight to loyalty and near zero weight to competence. It is natural for politicians to seek loyalty. However, when competence gets neglected, the results can be disastrous. And that’s exactly why the disaster has happened.

It has been a crazy week. The widespread speculation about devaluation, a ‘sudden’ 500 million LVL budget package, then its recall in less than a day, and then another budget package. Perhaps what we need is to distance ourselves from all the emotions of the last week and try to see the forest behind the trees. That is the aim of this article.

The Big Picture

Perhaps a good place to start is in 2004, when, in a report commissioned by the Ministry of Economy, we warned of the extremely poor state of this country's analytical capacity in economics. We said that the universities were full of Soviet-trained economists, whose quality could not be ascertained because they could not, or did not want to, publish in international peer-reviewed journals. We said it was vital to establish an independent economics research institute, as a first step to creating some badly needed capacity in economic analysis. Unfortunately, we were ignored, and our proposal was shelved.

What followed is history. Explosion in private credit and labor migration caused the economy to overheat, and pushed wages and prices up to the levels that were not sustainable in the long run. This was a classic case of overheating. Yet the government did not see this for what it was, and did the worst thing imaginable - it poured more fuel into the fire. Public sector salaries were raised dramatically, social programs were expanded, and expensive construction projects were commissioned, like the one billion euro South bridge. When the first signs of the global liquidity crunch appeared, the government, again, did not see the risks that it posed. Instead, it kept insisting that robust growth would continue. When the global financial crisis brought domestic vulnerabilities to head, the Latvian government quickly found out how Cinderella must have felt like at midnight, when her splendid coach turned into a pumpkin, and horses - into mice.

Clearly, the crux of the problem was that, as a result of overheating, the wage and price level became too high. The textbook solution would be to devalue the currency so as to restore competitiveness in the external markets and effect substitution domestically towards locally produced goods. But no - in its effort to cling to the only remnant of the national pride - the stability of the lats - the government launched this highly ambiguous experiment with deflation. Many independent economists (especially Westerners) warned of the many risks of deflation: that it does not happen very often meaning few have a good idea of how it really works, that it proceeds through destroying jobs, that it means strict adherence to fiscal austerity, and that it would, in all likelihood, take quite a long time. But, of course, these warnings were ignored as well. The government, again, said that Latvia was special; that economic laws did not work here. Luckily, it found powerful allies in the form of the Swedish government, which was concerned about the exposure of its banks, and the European Commission, which feared broad contagion effects to the whole of Central and Eastern Europe, and possibly beyond. And so the course for deflation was set.

The IMF and the EC clearly told the government that this plan’s success rested on the credible exit strategy – adoption of the euro ASAP. The thing is that the financial markets would find it hard to believe that this monstrous plan (deflation) could 'succeed' and the fear of devaluation would always be in the equation. As is well known, (lawful) adoption of the euro requires, among other things, budget deficit below 3% of GDP. A transition period was agreed to with the budget deficit of 5% of GDP in 2009. That was also the condition for disbursement of the next tranche of the loan. That was all well known since December last year, even to the government. Right after taking office in February, Prime Minister Dombrovskis said that the budget needed to be cut by about 700 million lats to avoid sovereign default. However, right before the local elections the government drafted a budget where the budget expenditure was reduced only by about 110 million lats, with the ensuing deficit of 9.2% of GDP. At this sensitive time, on June 3rd, someone real clever thought it was a good time to try to sell some government bonds. Naturally, the auction failed, unnerving financial markets and triggering a new round of speculation as to whether devaluation was imminent.

Then, with local elections out of the equation, the government produced this outlandish LVL 500 million fiscal package. What made it so bad was not the magnitude of the sum, for that was well known ever since the GDP was forecasted to fall by 18%. It was the haste with which it was produced (probably, in just a few days), and its long-term consequences for the economy.

Why the plan with progressive tax was a very bad idea

The crown jewel of the 'new' initiative was that the bulk of it was not about reducing budget expenditure, but about increasing taxes. In particular, the government planned to increase the VAT to 23% and introduce the progressive income tax where the top rate (40%) would be levied on income exceeding 800 LVL a month (bruto). Moreover, the tax rate for income less than 200 LVL a month would remain 23%. Thus, we would be talking about a pure increase in the tax burden for anybody who (officially) made more than 200 LVL a month. Ironically, I am generally a supporter of progressive taxation, which makes me very angry that the New Era has defiled the word "progressive tax" for years to come. What’s wrong with progressive tax that was devised by the government?

First of all, this would be some serious tax burden, relative to other countries. For example, in the United States, that "bastion of capitalism", the top tax rate of 35%(!) is only levied on monthly income in excess of 31 thousands USD. Tax rate for income that is approximately between 347 and 1414 LVL per month is only 15%. Or, compare to a more socialistic Sweden (courtesy of Jānis Skrastiņš). Take bruto (gross) salary of 973 LVL, which is roughly what is paid to a decent professional. Before the reform, the after-tax income is 702 LVL. After the reform - 621 LVL. In Sweden, the same bruto salary would leave you with an after-tax wage of 757 LVL. How many professionals would just migrate to Sweden?

Second, I have serious doubts that this tax reform would produce the 35 million LVL in tax revenue that Mr. Repse hoped for. The key word is "tax evasion". It is common knowledge that ‘envelope wages’ are very widespread in this country? Has anyone given any thought as to why this is the case? Quite simply, 23% personal income tax combined with 33% social payroll tax create a tax wedge (the share of labor cost paid in these taxes) that is more than 40% of the labor cost to the employer. That is one of the highest tax wedges in the world. The tax wedge is what creates an incentive to pay wages in envelopes, which is to the mutual benefit to both the employee and the employer. An effective increase in the personal income tax would create an even bigger incentive for envelope wages and would likely result in more tax evasion. Moreover, I think the sad truth is that there are not many people these days who feel a moral obligation to pay taxes to the government.

Third, and a corollary to my second point, is that the tax reform would have disastrous effect for the economy in the long run. Think of what envelope wages mean. They reduce labor costs of employers who pay wages in envelopes, as compared to those who pay their workers officially. Thus, this cost advantage will drive out all the firms that pay taxes, because they will find it hard to compete with those who do not. So envelope wages would tend to spread quickly. Also, envelope wages are likely to be more widespread among small firms, rather than large firms. The reason is that the tax authorities usually find it hard to monitor the (many) small firms, but find it easier to monitor large firms. Thus, a small firm would realize that becoming a large firm means losing the cost advantage granted by envelope wages. Small firms would have less incentive to grow, and that would be it. Quite simply, we would end up living in the economy populated by small businesses, spending much of their time thinking of tax evasion, rather than producing greater value added.

Fourth, the budget deficit is a public sector problem. With the economy contracting at the (likely) rate of 18% a year, it is obvious that the tax revenues would fall as well. Thus, it is simply a question of the public sector living within its means. This last point, however, raises the question as to why the government has found it so difficult to reduce spending. The Godmanis government could not do it, and Dombrovskis government was not much more successful. Surely both tried. Why was it so difficult?

Why is it so hard to reduce public spending

I think the problem was the obsession with the “structural reforms”, which continues to this moment. This is counterintuitive, so let me try to explain. There is something magic about these words, because hardly anyone really understands what they mean, but few have the courage to admit it. This is like some economists saying that the solution to an economic problem is "to increase productivity", which translates into "we really have no idea as to what should be done, but we don't want it to be our problem". Yet most people, especially in Latvia, don’t dare to question this advice because they’re afraid to look stupid. Well, these things should be questioned.

A structural reform is best thought of as a change in what economists call "institutions", which can be broadly defined as humanly devised constraints on human behavior, sort of ‘rules of the game’. Take, for example, higher education in economics. Obviously (to me), it needs a "structural reform" because, in my assessment, its performance is so seriously bad. Yet there are so many ‘rules of the game’ that can be changed here. Devising such a reform would require quite a lot of thinking by a lot of competent people. We are talking about months and possibly years. And that's just one area, whereas time (and competent people) is a scarce resource. Thus, the idea that the government could devise and implement a structural reform for a substantial part of the public sector in a matter of a few months is, quite frankly, ridiculous. At this point I should stress that I am not saying we don't need structural reform. What I am saying is that devising a good one takes lots of time and human capital. It just can't credibly be done in a few months.

I do not have accurate and detailed knowledge as what has been happening in the private sector over the last few months. However, my guess is that the government (I narrowly mean the Cabinet of Ministers here) has tried to implement “structural reform” in all of the public sector. I wouldn’t be surprised if instructions to, quite literally, “reduce spending by implementing structural reform” were passed down through the layers of subordination in all of the public sector. Further, I think that, in its attempt to pursue structural reform the government, the government overlooked an important thing: bureaucrats are not reformer’s best friends.

The paradox is that while every public agency is better off from a collective reduction in expenditure (default is averted), it is in individual interest of every agency to lobby for keeping its own expenditure, and to reduce expenditure of other agencies. It is too naïve to think of public officials as of selfless servants of the public interest. Bureaucrats are likely to be as self-interested as everybody else, and their interest is in having as large office as possible, because it maximizes their power. Thus, a top-down plan to cut spending is in conflict with a bureaucrat’s self-interest. Moreover, this is not a level playing field because a bureaucrat typically possesses monopoly on the expertise regarding various operational nuances of his agency. Thus, a natural strategy for a bureaucrat, who is ordered to reduce his budget, is to try to show that his agency is crucial to the society. A bureaucrat will have incentive to cut spending in a way that is most disruptive to society. Take the recent example of the Ministry of Defense. When ordered to reduce spending, the ministry announced it contemplated the return to universal conscription, which caused uproar in the public. Clearly, that was a strategy aimed at trying to keep a bigger chunk of the operating budget.

The above reasoning suggests that the only way to quickly reduce budget expenditure is to institute uniform, across-the-board cuts in all expenditure of the public sector, focused on the salaries. Naturally, this approach is the opposite of the “structural reform”, because it does not require tinkering with the individual public agencies. This is precisely the government’s latest plan and I think this is the right way to go. Pressing problems require immediate and realistic solutions. This country needs “structural reforms”, but first priority is to solve the most urgent problems using solutions that are best suited to the situation at hand.

However, this recent instance of good decision-making should be seen as more of an exception, rather than a rule. What was common in all the above episodes was dramatic lack of competence, especially when it comes to economics. This raises the following question.

Why does Latvia seem so much of a ‘failed state’?

It’s very tempting to say “it’s because politicians are stupid and incompetent”. However, that would not be the answer. Any phenomenon can be explained by saying that people are more or less stupid. And yet, it is hard to escape the conclusion that people in power often choose their entourage (public officials) by attaching a large weight to loyalty and near zero weight to competence. Examples are easy to come by. Take the story with Mr Šleser’s driver’s son, who, without any qualifications, was assigned to the board of a large state-owned company. Or, take Normunds Peterkops, who became a member of the Competition Council on the grounds of political affiliation alone, in spite of having zero experience with competition policy. How many public sector jobs are filled by the likes of Mr Peterkops? It is natural for politicians to seek loyalty – after all, that’s what allows them to exert influence, and that is what power is all about. However, when competence gets neglected, the results can be disastrous. And that’s exactly why the disaster has happened.

Why do Latvian politicians care more about loyalty, and less about competence? That is the question that should really be asked to the voters. Apparently, the politicians do not perceive that there is a punishment for incompetence. This means they think that competence is not the main factor in winning the votes. And this is where the search for the scape-goats ends. The suspect is staring at you from the mirror. We, the citizens and permanent residents of this country, make this state what it is. If this state is a failed one, it means that, whatever we do, we should try harder.

Danil - radenko@inbox.ru 09.10.2009 19:07
Call it loyalty, if you'd like. Electing a relative as board member of a state-owned company is corruption at it's core. Competency of government officials is certainly a key issue. However, none of the solutions will work when the agenda is to preserve own wealth and control the power. Do you truly think they care?

I am not in the habit of posting comments on public discussion boards but this article prompted me to add “my two cents” to the topic at hand. First of all, I would like to thank the author for the straightforward (but by no means simplistic) way in which he illustrates the enormity of the situation we find ourselves in, This, in itself, is no small feat. Secondly, I do not claim to be an expert in either economics or sociology, or political science, for that matter. Nevertheless, I will attempt to articulate my thoughts in this matter.

In my opinion, structural reform, defined as an attempt to change the “rules of the game” of “institutions”, is an insurmountable task. To understand this one would need to return to the distinction between “institutions” and “organisations”, where “organisations” are social entities that adhere to formal rules and have clear goals (in this case, government agencies, firms, schools etc), and “institutions” are social practices (i.e. the unwritten rules or “this is how we do things here”), which might or might not be instilled in “organisations” (for example, government organisations can be seen as “institutions” but so can be marriage). Hence, the reforms proposed by the government are attempting to change the organisations without changing the underlying institutional practices.

“Old habits die hard” and this is certainly true for the government in Latvia. For a long time, the government has been operating in an incompetent fashion, as the author rightly points out, and it got away with it. It got away with it because the wider public has accepted by now that this is what politicians and civil servants are like. It has become the norm.

An obvious solution to this dilemma would be the change in the “rules of the game”. However, I do not believe that this can be either adequately planned for or enforced, even by the most competent experts. Why? Because the “institutions” that are in charge of the decision making in Latvia and perceive loyalty to their peers as their main priority, will not stand for it. This, I believe, is also why the government has been dormant in enforcing the necessary reforms despite the warning signs. I should imagine it hoped the crisis will blow over, and frankly, this is how it has operated for years – ignoring the warning signs and making decisions only when the going gets tough.

Now, let us assume that a person comes along, who is competent and willing to take on the challenge of reforming the government, especially, its practices. Surely, he will be shown his place in the hierarchy in no time. As for the average citizen, voting for one candidate/party or another will not change the rules once these become members of the “institution” we broadly call the government. The only plausible way to change this vicious circle is to institute a powerful enough deterrent for certain practices and to follow through in its implementation but I do not think the proposed measure will find much support in the government or the public at large.